Derivatives

5. DERIVATIVES
What are Types of Derivatives?
Forwards: A forward contract is a customized contract between two
entities, where settlement takes place on a specific date in the future at
today’s pre-agreed price.
Futures: A futures contract is an agreement between two parties to buy or
sell an asset at a certain time in the future at a certain price. Futures
contracts are special types of forward contracts in the sense that the former
are standardized exchange-traded contracts, such as futures of the Nifty
index.
Options: An Option is a contract which gives the right, but not an
obligation, to buy or sell the underlying at a stated date and at a stated
price. While a buyer of an option pays the premium and buys the right to
exercise his option, the writer of an option is the one who receives the
option premium and therefore obliged to sell/buy the asset if the buyer
exercises it on him. Options are of two types - Calls and Puts options:
‘Calls’ give the buyer the right but not the obligation to buy a given
quantity of the underlying asset, at a given price on or before a given
future date.
‘Puts’ give the buyer the right, but not the obligation to sell a given
quantity of underlying asset at a given price on or before a given
future date.
Presently, at NSE futures and options are traded on the Nifty, CNX IT, BANK
Nifty and 116 single stocks.
Warrants: Options generally have lives of up to one year. The majority of
options traded on exchanges have maximum maturity of nine months.
Longer dated options are called Warrants and are generally traded over-thecounter.
What is an ‘Option Premium’?
At the time of buying an option contract, the buyer has to pay premium. The
premium is the price for acquiring the right to buy or sell. It is price paid by
the option buyer to the option seller for acquiring the right to buy or sell.
Option premiums are always paid upfront.
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What is ‘Commodity Exchange’?
A Commodity Exchange is an association, or a company of any other body
corporate organizing futures trading in commodities. In a wider sense, it is
taken to include any organized market place where trade is routed through
one mechanism, allowing effective competition among buyers and among
sellers – this would include auction-type exchanges, but not wholesale
markets, where trade is localized, but effectively takes place through many
non-related individual transactions between different permutations of buyers
and sellers.
What is meant by ‘Commodity’?
FCRA Forward Contracts (Regulation) Act, 1952 defines “goods” as “every
kind of movable property other than actionable claims, money and
securities”. Futures’ trading is organized in such goods or commodities as
are permitted by the Central Government. At present, all goods and
products of agricultural (including plantation), mineral and fossil origin are
allowed for futures trading under the auspices of the commodity exchanges
recognized under the FCRA.
What is Commodity derivatives market?
Commodity derivatives market trade contracts for which the underlying
asset is commodity. It can be an agricultural commodity like wheat,
soybeans, rapeseed, cotton, etc or precious metals like gold, silver, etc.
What is the difference between Commodity and Financial
derivatives?
The basic concept of a derivative contract remains the same whether the
underlying happens to be a commodity or a financial asset. However there
are some features which are very peculiar to commodity derivative markets.
In the case of financial derivatives, most of these contracts are cash settled.
Even in the case of physical settlement, financial assets are not bulky and
do not need special facility for storage. Due to the bulky nature of the
underlying assets, physical settlement in commodity derivatives creates the
need for warehousing. Similarly, the concept of varying quality of asset does
not really exist as far as financial underlyings are concerned. However in the
case of commodities, the quality of the asset underlying a contract can vary
at times.